Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

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China easing as data softens

China’s decision over the weekend to cut the required reserve ratio (RRR) by 100bp (effective Oct 15), the fourth cut this year, will inject around CNY 750bn in liquidity into China’s money markets. The decision to ease comes in the wake of a run of recent soft data.   There should be no big surprise.  China is reluctant to ease policy via a policy rate cut to avoid fuelling any increase in leverage and therefore continues to embark on targeted easing in the form of RRR cuts.

It is likely that further RRR cuts in addition to fiscal stimulus are in the pipeline to cushion the slowdown in the economy.   Indeed, growth was already slowing before the US tariffs impact bites and will likely slow further in the months ahead as the impact of tariffs has a greater effect.   Recent forward looking data including the official and CAIXIN purchasing managers’ indices (PMIs) of manufacturing confidence have softened, with the exports component of the PMIs dropping significantly.

Such cuts will weigh on China’s currency, CNY/CNH and a continued spot depreciation versus USD is likely.   After its sharp decline in June/July FX the PBoC has succeeded in stabilising the CNY (in trade weighted terms) however.   Any decline in foreign exchange reserves has been limited as reflected in the latest FX reserves data, which revealed that FX reserves dropped by $22.7bn only in September, suggesting that as yet there have not been significant capital outflows (ie panic) from China and limited need for FX intervention to support the CNY.

Worsening China Economic News

There was more bad news on the data front from China.  Data released yesterday revealed a further slowing in the manufacturing sector. The Caixin purchasing managers index (PMI) dropped to 50.0 in September, its lowest reading since May 2017. This index which is far more weighted towards smaller companies is more sensitive to export concerns. Further pressure on sentiment is likely over coming months as tariffs bite, with prospects of another $267bn of US tariffs against China still very much alive.

The official China manufacturing PMI fell to 50.8, its lowest since February 2018, from 51.3 in August. Reflecting worsening trade tensions, the new export orders component of the index fell to 48, its fourth consecutive contraction and lowest reading since 2016. In contrast the non-manufacturing PMI strengthened to 54.9 from 51.2 in August reflecting firm service sector conditions. S

Separately China’s central bank, the PBoC stated on Saturday that it will maintain a prudent and neutral monetary policy stance while maintaining ample liquidity. This implies further targeted easing. The data may fuel further pressure for a weaker Chinese currency path in the weeks ahead though it is unlikely that China will revert to the fast pace of CNY depreciation registered over June.

 

US dollar weakness providing relief

The US dollar index has weakened since mid-August 2018 although weakness in the broad trade weighted USD has become more apparent since the beginning of this month.  Despite a further increase in US yields, 10 year treasury yields have risen in recent weeks to close to 3.1%, the USD has surprisingly not benefited.  It is not clear what is driving USD weakness but improving risk appetite is likely to be a factor. Markets have been increasingly long USDs and this positioning overhang has also acted as a restraint on the USD.

Most G10 currencies have benefitted in September, with The Swedish krona (SEK), Norwegian Krone (NOK) and British pound (GBP) gaining most.  The Japanese yen (JPY) on the other hand has been the only G10 currency to weaken this month as an improvement in risk appetite has led to reduced safe haven demand for the currency.

In Asia most currencies are still weaker versus the dollar over September, with the Indian rupee leading the declines.  Once again Asia’s current account deficit countries (India, Indonesia, and Philippines) have underperformed most others though the authorities in all three countries have become more aggressive in terms of trying to defend their currencies.  Indeed, The Philippines and Indonesia are likely to raise policy interest rates tomorrow while the chance of a rate hike from India’s central bank next week has risen.

As the USD weakens it will increasingly help many emerging market currencies.   The likes of the Argentinian peso, Turkish lira and Brazilian real have been particularly badly beaten up, dropping 51.3%, 38.5% and 18.8%, respectively this year.  Although much of the reason for their declines have been idiosyncratic in nature, USD weakness would provide a major source of relief.  It’s too early to suggest that this drop in the USD is anything more than a correction especially given the proximity to the Fed FOMC decision later, but early signs are positive.

 

Trade war heats up

After the US administration announced that it will impose tariffs on $200 billion of Chinese imports to the US, China responded by announcing retaliatory tariffs on $60 billion of US goods.

The US tariffs of 10% will be implemented on September 24.  The tariffs could rise to 25% by the beginning of next year if no deal is reached between the US and China. This is important as it implies some breathing space for a deal and means that the immediate impact is less severe.

There have been some exemptions on goods that were on the original list including smart watches and Bluetooth devices. Aside for allowing time for negotiation the delay in increasing to 25% to 1 Jan 2019 also gives US manufacturers time to look for alternative supply chains.

The reality is that these tariffs should not be surprising. There has been little room for compromise from the beginning. China wants to advance technologically as revealed in its “Made In China 2025” policy as part of its efforts to escape the so-called middle income trap by fostering technological progress and movement up the value chain.

In contrast the US clearly sees China’s policy as a threat to its technological dominance especially as the US holds China responsible for intellectual property theft and forced technology transfers.US administration hawks including trade advisor Peter Navarro and US trade representative Lighthizer were always unlikely to accept anything less than a full blown climb down by China, with moderates such as Treasury Secretary Mnuchin and head of the National Economic Council Kudlow unable to hold enough sway to prevent this.

President Trump stated that if China retaliates the US will pursue further tariffs on the remainder of $267bn of Chinese imports. This now looks like a forgone conclusion as China has retaliated.

Further escalation from China could target US energy exports such as coal and crude oil. China could also target key materials necessary for US hi-tech manufacturers. Another option for China given the lack of room for tit for tat tariffs is to ramp up regulations on US companies making it more difficult to access Chinese markets. It could give preference to non-US companies while Chinese media could steer the public away from US products. Such non trade measures could be quite impactful.

It seems unlikely that after allowing a rapid fall in the renminbi (CNY) and then implementing measures to stabilise the currency (in trade weighted terms) China would allow another strong depreciation of the CNY to retaliate against US tariffs. Even so, as long as China can effectively manage any resultant capital outflows and pressure on FX reserves, it may still eventually allow further CNY depreciation versus the USD amid fundamental economics pressures.

Turkey hikes, ECB and BoE don’t. Trump dampens trade hopes

Despite comments from Turkish President Erdogan railing against prospects for a rate hike, Turkey’s central bank, CBRT hiked the repo rate to 24%, a much bigger than expected 625bp increase.  This may not be sufficient to turn things round sustainably but will at least prevent a return of the extreme volatility seen over past weeks.  The decision saw USDTRY drop by about 6% before reversing some of the move.  Undoubtedly the decision will provide support to EM assets globally including in Asia today.

Elsewhere the European Central Bank (ECB) delivered few punches by leaving policy unchanged and reaffirming that its quantitative easing will reduce to EUR 15bn per month (from EUR 30bn) from October while anticipating an end after December 2018.   The ECB also downgraded its growth outlook but kept the risks broadly balanced.  The outcome will likely to help put a floor under the EUR.  Unsurprisingly the Bank of England (BoE) left its policy on hold voting unanimously to do so, leaving little inspiration to GBP.

President Trump poured cold water on US-China trade talks by denying a Wall Street Journal article that he faces rising political pressure to agree a deal with China.  Trump tweeted, “They are under pressure to make a deal with us. If we meet, we meet?” . Meanwhile US CPI missed expectations at 0.2% m/m, 2.7% y/y in August, an outcome consistent with gradual rate hikes ahead.   The data will also help to undermine the USD in the short term.

Catching a falling knife

After a very long absence and much to the neglect to Econometer.org I am pleased to write a new post and apologise to those that subscribed to my blog, for the very long delay since my last post.   There is so much to say about the market turmoil at present, it is almost hard not to write something.

For those of you with eyes only on the continued strength in US stocks, which have hit record high after record high in recent weeks, it may be shocking news to your ears that the rest of the world, especially the emerging markets (EM) world, is in decidedly worse shape.

Compounding the impact of Federal Reserve rate hikes and strengthening US dollar, EM assets took another blow as President Trump’s long threatened tariffs on China began to be implemented.  Investors in countries with major external vulnerabilities in the form of large USD debts and current account deficits took fright and panic ensued.

Argentina and Turkey have been at the forefront of pressure due the factors above and also to policy inaction though Argentina has at least bit the bullet. Even in Asia, it is no coincidence that markets in current account deficit countries in the region, namely India, Indonesia, underperformed especially FX.  Even China’s currency, the renminbi, went through a rapid period of weakness, before showing some relative stability over recent weeks though I suspect the weakness was largely engineered.

What next? The plethora of factors impacting market sentiment will not just go away.  The Fed is set to keep on hiking, with several more rate increases likely over the next year or so.  Meanwhile the ECB is on track to ending its quantitative easing program by year end; the ECB meeting this Thursday will likely spell out more detail on its plans.  The other major central bank that has not yet revealed plans to step back from its easing policy is the Bank of Japan, but even the BoJ has been reducing its bond buying over past months.

The trade war is also set to escalate further.  Following the $50bn of tariffs already imposed on China $200 billion more could go into effect “very soon” according to Mr Trump. Worryingly he also added that tariffs on a further $267bn of Chinese goods could are “ready to go on short notice”, effectively encompassing all of China’s imports to the US.  China has so far responded in kind. Meanwhile though a deal has been agreed between the US and Mexico, a deal encompassing Canada in the form a new NAFTA remains elusive.

Idiosyncratic issues in Argentina and Turkey remain a threat to other emerging markets, not because of economic or banking sector risks, but due increased contagion as investors shaken from losses in a particular country, pull capital out of other EM assets.  The weakness in many emerging market currencies, local currency bonds and equities, has however, exposed value.  Whether investors want to catch a falling knife, only to lose their fingers is another question. which I will explore in my next post.

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